A Leading Indicator: Corporate Stock Buy-Backs

I must admit to being wrong.  I believed that the big cash buildup at corporations would be used to fuel a mergers and acquisitions binge.  I thought that the economic recovery was strong enough that the “better off” corporations would “pick off” all the low-hanging fruit offered by the companies that were not in a very good position coming out of the Great Recession. 

I argued that this behavior would not accelerate economic recovery because the restructuring taking place would result in consolidations and debt reductions that would just make industry more productive somewhere down the line but add very little to economic growth and lower unemployment in the present.

Merger activity has been fairly high this past year but not as great as I thought it would be.    

Where I was wrong…was in the strength of the recovery.  The economic recovery is not strong enough to propel the M&A binge I expected. 

So, what are the cash accumulations and the low borrowing rates leading to? 

Corporations buying back their own stock.

“US companies are on pace to announce buy-backs of more than $500 billion worth of shares this year, according to stock research firm Birinyi Associates, the third biggest year on record.” (http://www.ft.com/intl/cms/s/0/546f97ec-1231-11e1-9d4d-00144feabdc0.html#axzz1fwprkyNi)

The message is that the economy is not recovering sufficiently to warrant more acquisitions and the stock markets have not been robust enough to provide higher valuations for market shares, so, the companies with the cash or with access to the cash are buying back their stock at prices they believe to be ridiculously low. 

This can have some consequences for firms.  For example, Safeway, Inc., sold $800 million in bonds last week and, the same day, management disclosed that it was buying back $1 billion worth of its own common shares. 

The rating agency, Fitch Ratings, immediately dropped the company’s credit rating by one notch to triple B minus. 

A similar thing happened to Amgen and Lowe’s.  Last month, Amgen sold $6 billion worth of bonds to buy back its stock early in November…and Moody’s Investors Service cut Amgen’s bond rating by one notch while Fitch cut its rating by two notches.  Lowe’s sold bonds in November to buy back stock, which resulted in downgrades by Moody’s and Standard & Poor’s. 

That is, the debt issue followed by the stock buy back increased the financial leverage of these companies and hence make their debt riskier.

Stock buy backs, however, do not increase economic growth!

What is happening?

Long-term interest rates in the United States are being kept down by the actions of the Federal Reserve and the flight of money from Europe seeking a “safe haven” in United State Treasury bonds.  The Fed wants to get the economy going again and has said it will keep rates at historically low levels for another two years or so.  And, “with corporate bonds benchmarked to US Treasuries, whose yields have fallen to historic lows amid strong demand for havens, borrowing costs fro investment grade companies have also fallen.”

So what do we have…low economic growth and credit growth that exceeds the “productive” needs of the corporations. 

In essence this is a picture of credit inflation.  To be sure, we are not seeing the creation of credit raising consumer or wholesale prices at this stage…but, when credit expansion exceeds the real growth rate of the economic sector that the funds are going into we get a “dislocation” that can lead to problems in the future.

That is why, to me, the acceleration of corporate stock buy-backs in this instance seems to me to be a leading indicator of dislocations in the economy that will have to be dealt with at a later time.

“Although bondholders generally do not like these transactions (issuing bonds to buy back stock) because of the risk they pose to companies’ credit ratings, most of the groups buying back shares this year with debt have not seen too much fall-out from the bond markets or from credit rating agencies.”

This is always the case.  Those that move first and move rapidly get the most benefits from their actions.  Only later, when many others attempt the same thing, do markets…and credit rating agencies…move more…or produce greater “fall-out.”

“The deals, then, are likely to continue so long as investors keep buying bonds and pressuring rates.”

And, as the Fed works to keep interest rates so low.

The concern about corporate stock buy-backs being a leading indicator?

If economic growth does not pick up a greater speed (http://seekingalpha.com/article/312223-the-focus-should-be-on-underemployment-not-unemployment) and if the Fed continues to maintain the excess reserves it has pumped into the banking system and keep interest as low as it has promised to do, then we need to be aware of where the dislocations are forming in the economy. 

And, be assured, if this credit inflation begins to show up in some places…it will also begin to show up in other places as time passes.  That is, fault lines are created in the economy much as Raghuram Rajan has described in his award winning book called “Fault Lines: How Hidden Fractures Still Threaten the World Economy.”  And, fault lines make everything more fragile.   

The Merger Binge and the Economy

We wondered what Microsoft was up to when it started issuing long-term debt last year, something that it had never done all the rest of the time it has been a public company. 

This money was not going to go to expand operations.  It already had tons of cash to do that!

The best bet was that Microsoft was going to go acquiring…but, what.

Now we have a partial view…Microsoft…and Steve Ballmer…is buying Skype!  The estimated cost?  More than $8 billion.

What about all the other money Microsoft raised in the bond market?  My best guess is that we will see more acquisitions in the future!

But, Microsoft is not alone in this.  Hertz is going after Dollar Thrifty and outbidding Avis.  Southwest Airlines acquired AirTran Holdings to get into the Atlanta airport, the world’s busiest. 

And the beat goes on.

AT&T is intent on acquiring T-Mobile for around $39 billion; Johnson & Johnson has a $21.5 billion deal in the works for Synthes; Duke Energy plans to merge with Progress energy, the deal totaling a little less than $14 billion; and there is the bid for NYSE Euronext for more than $11 billion.

I have been arguing for at least a year now that much of the cash being built up at many large corporations was going to contribute to a major acquisition binge…worldwide. 

And, this binge would include companies from more and more nations.  The Chinese are looking to put $200 billion into corporate acquisitions globally.

Roger Altman, Chairman of Evercore Partners, Inc., argues that the deal making will be at an all time high in 2011, surpassing the $4 trillion record total that was achieved in 2007. (http://www.bloomberg.com/news/2011-05-06/altman-sees-dealmaking-recovery-surpassing-record-4-trillion-of-2007-boom.html)

Some analysts argue that the growing stability of the economy is contributing to this.  Others attribute this movement to the strength in the stock market. 

Whereas these support the cumulative rise in the amount of M & A activity taking place, I still believe that this record-breaking rise in acquisition activity is being subsidized by the monetary policy of the Federal Reserve System. 

The first to benefit from this subsidy are those companies that came through the Great Recession with little or no debt on their balance sheets. 

The second group to benefit have been those that have been able to use leveraged loans and junk bond issues to refinance billions of dollars of debt borrowed during the credit inflation of the past decade or so. 

These companies are now buying other companies and strategically positioning themselves for the future.  And, in a real sense, the big are getting bigger…and more complex.  Industry is following the banks on this as the larger firms are getting greater market share and expanded market space. 

And, in my experience, there is only one way to really make acquisitions work.  The acquirers, after the deal is made, must become the biggest “bastards” in the world.  That is, the acquirers must become ruthless in rationalizing their purchase…otherwise…the acquisition just won’t pay off.

The effect on the economy?  In the longer-run…good…very good!  In the short run…continued pain.  Jobs must be cut, un-economic facilities must be disposed of, and, in general, spending must be reduced. 

“In AT&T’s pending deal for T-Mobile USA, the companies estimate cost savings of $40 billion over time, including expected layoffs, starting from the third year after the merger is completed.” (http://professional.wsj.com/article/SB10001424052748704810504576305363524537424.html?mod=ITP_moneyandinvesting_0&mg=reno-wsj)

But, this gets into another point I have been trying to make for the past two to three years.  During this time I have argued that about one-in-four to one-in-five people of working age are under-employed.  Forget the unemployment rate as it is measured…there are a lot of individuals that have either left the labor market or are not fully employed but would like to be.  And, this has been a growing problem over the past half-century. 

The merger and acquisition binge is not going to help this situation…one bit!

David Brooks in his New York Times column this morning emphasis this problem. (http://www.nytimes.com/2011/05/10/opinion/10brooks.html?_r=1&hp)  Brooks reports that 80 percent of “all men in their prime working ages are not getting up and going to work…there are probably more idle men now than at any time since the Great Depression and this time the problem is mostly structural, not cyclical.”

And, the primary factor that distinguishes the unemployed?  Not sufficient educational training.  “According to the Bureau of Labor Statistics, 35 percent of those without a high school degree are out of the labor force.”  Not unemployed…but, “out of the labor force”!  And, while this number goes down the more education one has, there is still a close correlation between the number of individuals “out of the labor force” and the amount of education that an individual has.   

And, as the mergers and acquisitions take place, the trend will just worsen.  For too long a time, when unemployment arose, we have tried to put people back into the jobs they had formerly held, even though those jobs became less and less economically justified.  The expectation was that the government would stimulate the economy and people would get their old jobs back.

Now we are going through a transition in which those “old jobs” are no longer there. 

And, the monetary stimulation coming from the Federal Reserve System is now resulting in a continued reduction in the less productive jobs through the merger and acquisition banquet going on and is doing very little toward helping these people get back into the work force.

This is consistent with the argument that I have continuously made in these posts that the credit inflation created by the monetary and fiscal policy of the United States government over the past fifty years has done a very good job in splitting the labor force into two segments, the less educated and the more educated, and the society into a much more highly skewed income distribution than earlier.

The acquirers have the cash, they can still borrow at ridiculously low interest rates, and these conditions are expected to stay in place for “an extended period.”  Continue to watch all the M&A activity taking place.  I think this will be a time to remember.

Merger Trend Heats Up

For the last 18 months or so, I have believed that one of the most important factors affecting the American (and world) economy would be a growing number of mergers and acquisitions. Individuals at Credit Suisse Group AG estimate that “The value of global takeovers may increase 15 percent to 20 percent this year, extending a 27 percent rebound in 2010.” (http://www.bloomberg.com/news/2011-03-30/new-deal-rush-pushes-takeovers-to-most-expensive-since-lehman.html) Not only is the economy growing (however modestly) but the better off corporations have lots and lots of cash assets, borrowing costs are exceedingly low, and there are lots of other corporations that are not so well off and whose best outcome is to be acquired by someone larger and healthier. Last week the AT&T and T-Mobile deal was announced. Recently we have also had deals announced by Duke Energy Corporation and Deutsche Boerse AG. And, yesterday, Canada’s Valeant Pharmaceuticals International put out a hostile offer for Cephalon, Inc. General Electric has engaged in a string of acquisitions, the most recent one was just announced, a $3.2 billion deal for GE to acquire the French company Converteam. And, there are many others. Deals are also taking place in the commercial banking industry. Although there were 157 banks closed in 2010, the number of banks in the industry fell by 310 indicating that lots of acquisitions were going on behind the information relating to the regulatory closures taking place. And, the big companies are getting bigger. The prices of an acquisition are rising. In the first quarter of this year, the price of an acquisition reached the highest level since before the collapse of Lehman Brothers Holdings, Inc. There are three aspects of this activity that are important for our future. First, consolidations are taking place across virtually all industries. There are many targets “out there” and companies with lots of cash and lots of borrowing power are “on the prowl.” This activity will have two effects on economic growth. In the short run, consolidations slow down economic growth because they lead to a rationalization of industry where plants and offices are closed and people are let go. Over the longer run, productivity increases as organizations become more efficient and effective producers of goods and services. Second, companies that have built up too much debt are in the process of deleveraging and, at the same time, are spinning off some of the subsidiaries they acquired with the debt. Thus, firms are getting back to more manageable levels of debt in their capital structure and they are also returning their operational focus to their core businesses. Both of these moves will also tend to keep economic growth from speeding up in the near future. The reduction in the debt of these companies will not be replaced in the near future and this will moderate the increase in bank lending and other corporate borrowing. Furthermore, the return of companies to their core businesses tends to result in the closing of plants and offices and the reduction in the number of people these companies employ. Third, investors will have the opportunity to participate in the restructuring of the economy that is now taking place. However, investors must be careful because not all acquiring companies are equal and not all acquisitions will turn out well. The current merger and acquisition boom is still in its early stages. As such, premiums received by selling companies are low, “the lowest since the third quarter of 2007.” Premiums are always low at the start of an M&A boom! Yet, not all deals are attractive to investors. Whereas AT&T stock has climbed 7.6 percent since it disclosed the T-Mobile deal and Valeant Pharmaceuticals stock jumped 15 percent late yesterday on the news of its bid for Cephalon, other transactions have not fared so well. If there is a chance to participate in this investment swing, it is now, when the purchase premiums are low. These will rise, and in the typical cycle, the rise will approach a level in which all new M&A deals are suspect. How soon the rise will occur is, of course, problematic. With so much cash on company balance sheets and the Federal Reserve holding market interest rates so low, one could imagine that the bidding could become pretty hot. But even if the bidding becomes “hot” this will not do much good for the economy in the short run because consolidations and the rationalizing of companies will result in plant and office closings and the laying off of people. It will also result in big companies (and big banks) getting bigger.

Bigger is Happening!

AT& T and T-Mobile. The strategic merger activity of 2011 and 2012 continues.

As I have argued for a long time, the environment for a crucial restructuring of the economic world is right in front of us.

There is lots of cash around.

Interest rates are ridiculously low.

There are a lot of people, businesses, and governments “defensively” in debt.

There are a lot of companies that are “behind”, technologically and culturally, that have “good” products or good market niches.

And, there are a lot of nations in the world, like China for example, that have a lot of United States dollars that want to buy United States companies.

What about the anti-trust aspects of strategic mergers like AT&T and T-Mobile?

First, I don’t think the executives at AT&T and T-Mobile would try a combination like this if the probability of getting the deal approved were low.

Second, we are in a period of time when the “limits” of what can be done are going to be pushed. Thus, we will see more and more deals “push the edge.”

Third, if it ain’t AT&T and T-Mobile, it will be someone else and, I believe, the crucial issue is going to be how far the regulators are behind-the-times and out-of-date rather than the fact that they are enforcing some coherent program or policy.

Fourth, this is more “global” than it is “local” United States. Regulators, attempting to live up to some historical norms of anti-trust behavior, can stifle deals and leave the United States lagging in world competition. If the members of Congress and the regulators want to continue to fight “past” wars, as they tend to do, then so much the worst for us.

The thing is that Congress and the regulators have already “taken their eye off the ball.”

A report released just the other day indicated not only that banks are big and doing much of what they did before the financial crisis, the large banks are actually bigger and doing even more things than they did before the financial crisis.

The meltdown in the financial system came in the fall of 2008. I was posting blogs in late Spring of 2009 that the large commercial banks were not only getting bigger, but they were far ahead of the Congress and the regulators writing new rules and restrictions for them.

Now the large banks are even further ahead of the government than they were back in the spring of 2009.

But, this is the scenario for the future.

And, the people creating the environment for such a development are…

You guessed it…Ben Bernanke, Tim Geithner, Barack Obama, Barney Frank, and so on and so forth!

No wonder the income distribution in the United States gets skewed more and more toward the wealthy. The wealthy could not have written a better script for their advancement than that being written by the liberals and the progressives!

And, the more these people try and help their “constituencies” the more and more they hurt them. Paul Krugman, stand up and take a bow!

The best investments in the next year or so, I believe will be made in the companies that are best positioned to make “deals” that will help them expand markets, expand into slightly larger product spaces, and move to restructure industries and markets.

I wouldn’t always argue that this is a good strategy, but the world has changed and we are moving into that future. There are many companies that are well positioned, they are operating very effectively in their “core” products and markets, they don’t have much debt, and they have lots of cash.

Furthermore, prices are low since there are many more companies that are not well positioned, companies that are not operating very effectively, companies that are into too many products and markets, and companies that have way too much debt.

And, we are in that part of the cycle where sound economic deals can be struck. In a year or two, premiums will start to rise as people look back and see the transactions made in 2010 and 2011 and as these people move to try and skim some of the icing off the cake themselves.

This always happens as the euphoria in the market picks up due to the previous successful deals that were cut.

So, keep your eyes open and look for the action taking place. Look not only at the companies that are operating very well and have lots of cash and/or borrowing power but look at the nations that have United States dollars and are looking to play a bigger role in the world. Look for executives that do not buy companies too different from the ones they operate now.

Also, look for the leaders that are starting to make a name for themselves in terms of “prudent” yet aggressive deals. Who is going to take on the mantel of the next Jack Welch?

The Real Reason for Fed Easing? Debasement Inflation?

Well, one of my major arguments made it to the op-ed page of the Wall Street Journal today, but I didn’t write it: Andy Kessler, a former hedge-fund manager wrote it. I agree with most of what Mr. Kessler says in his piece, “ What’s Really Behind Bernanke’s Easing?” (See http://professional.wsj.com/article/SB10001424052748704648604575621093223928682.html?mod=WSJ_Opinion_LEFTTopOpinion&mg=reno-wsj.)

I have been arguing for more than a year that the real concern of the Federal Reserve is the solvency of the banking system. The Fed’s given arguments for pumping so much liquidity into the banking system is that the economy is weak and the level of unemployment is unacceptable. The Chairman of the Board of Governors of the Federal Reserve System cannot say just say out loud that “the banking system is at risk.” Nor can any other Federal Reserve figure say this out loud.

My concern over the past year of so has constantly been that the economic and financial situation did not warrant the injection of all the Fed was throwing at it. See my post “Bernanke’s next round of spaghetti tossing”: http://seekingalpha.com/article/233773-bernanke-s-next-round-of-spaghetti-tossing.) A recent post continues to exhibit my belief that the justification for the Fed actions has been the solvency of the banking system and not just the health of the economy: http://seekingalpha.com/article/229385-is-a-crunch-coming-for-smaller-banks.

But, the behavior of the central bank not only represents concern for the commercial banks, but also for the real estate market. Elizabeth Warren, in Congressional testimony earlier this year, indicated that 3,000 commercial banks were threatened over the next 18 months or so, especially in loans in the area of commercial real estate. Plus, we have a massive problem in the municipal bond markets concerning the solvency of our state and local governments. The pension programs of these entities loom large over the financial markets and many individuals I know that work in this sector are scarred silly.

The efforts of the Fed, therefore, are attempts at “debasement inflation”. This was uttered by William Browder, who now runs an investment fund in London. (In the morning New York Times: http://dealbook.nytimes.com/2010/11/18/from-russia-expert-a-gloomy-outlook/?ref=todayspaper.) “Emerging markets went through more than a decade ago in the Asian Financial crisis what developed markets are experiencing now.” Browder added, “you want to own hard things that can’t be printed.”

But, these efforts extend beyond the borders of the United States. Given the fluidity associated with funds flowing throughout the world, the additional liquidity extends to the situation related to many Euro-nations in terms of their sovereign debt. Writedowns are going to occur in Ireland, Portugal, Greece, and possibly Spain and Italy. Even France is feeling some of the heat. International financial markets also need liquidity.

The question here is whether this concern over sovereign debt will extend to the United States. Browder goes on to say that there are limits to how much governments are able to borrow. And, investors move from one weak market to another. Eventually, these investors work through to even the “strongest” of the fiscally challenged states. When it gets to this stage, he argues, the only thing these governments can still do is print money.

Where are the hard assets? Real estate. Commodities. Companies.

These are the areas that will attract a lot of the money going around.

The prices of commodities have already experienced a significant bounce. This will continue.

Big money will also eventually be made in real estate and the merger and acquisition business of corporations. The prelude to this is the massive buildup in the cash holdings at many of the largest companies in the world, in the largest commercial banks in the world, and in hedge funds and other private equity funds. And, really, the move has already started in a very selective way.

I continue to believe that over the next five years of so we will see a substantial acquisition of assets, across the board, of a size we can barely imagine now.

The objective of the Federal Reserve is to keep things as stable as possible so that the FDIC can continue to close banks as smoothly as it can; that mergers and acquisitions can occur in an orderly fashion so that weaker institutions can be removed from the scene; and that more and more money will move into the real estate area so as to eventually put a floor under real estate prices.

All this may be done, but it may not exactly take the path that Mr. Bernanke would like it to take. Furthermore, all of this activity may not achieve the goals that President Obama would like to achieve.

Mr. Kessler argues that, in his view, the stock market will not view these developments as favorably as they have received earlier efforts at spaghetti throwing. He claims that this attitude has been shown by the recent behavior of stock prices. In addition, bond yields have backed up (prices of bonds have fallen) not what quantitative easing was devised to do. Both of
these outcomes are “exactly the opposite of what Mr. Bernanke was trying to achieve.”

In the case of mergers and acquisitions and the acquisition of real property, the early results are indicating that the bigger organizations are getting bigger, both financial and non-financial institutions, and the wealthy are getting wealthier. These outcomes are exactly the opposite of what President Obama was trying to achieve.

Mr. Browder spoke to students at the Columbia Business School several weeks ago. He argued that “the high-inflation scene” described above “could be another lucrative opportunity” similar, although not as great, to one he made so much money in while in Russia.

In such a situation, therefore, the emphasis in investing should be on what companies or assets can be acquired that will benefit from the credit inflation. Caterpillar, for example, moved into the mining equipment field, one reason being that mining will benefit from the surge in demand coming from emerging nations like China and Brazil. So, one is looking for “targets” and not long-term value creation.

One has to be careful, however, in buying into acquiring companies. Not all companies are good acquirers. History shows that many acquirers have to “unwind” their acquisitions within five years or so because the purchases are done for the wrong reasons or the managements cannot effectively integrate the properties they have obtained. However, there may be some very good “buys” amongst the acquirers.

For example, the value of the Caterpillar stock went up after the acquisition was announced. There is the feeling that the Caterpillar management can effectively put the two companies together to the benefit of the shareholders.

The Federal Reserve is creating a lot of opportunities with its new policy stance. However, the beneficiaries of the policy may not be the people it wants to help: the unemployed and the less-well-off.

Whither Economic Policy? Whither Investments?

President Obama has returned to Washington, D. C. We are told that he plans upon his return to focus on domestic economic issues.

The president has had two weeks that have not necessarily been the best of his administration. The mid-term election did not go the way he wanted and his sojourn into the international waters of the East did not go swimmingly.

Now, where is he going to go on the economic front?

His economic team is crumbling before his eyes and Ben and Tim are not getting the best critical reviews.

The economic news is not exactly what he would like to hear. It seems as if the results the economy is posting are exactly the opposite of what he has tried to do.

The front page of the Wall Street Journal trumpets: “Paychecks for CEOs Climb”. Here are the opening words:

“The chief executives of the largest U.S. public companies enjoyed bigger paydays in their latest fiscal year, as share prices recovered and profits soared amid the country's slow emergence from recession.

At these 456 companies, the median pretax value of CEO salaries, bonuses and long-term incentives, such as grants of stock and stock options, rose by 3% to $7.23 million, according to an analysis of their latest proxy filings for The Wall Street Journal by consulting firm Hay Group.

The Journal usually tracks executive compensation each spring. To provide a fuller post-recession picture, it followed up this year by analyzing pretax CEO pay at every U.S. public company with at least $4 billion in annual revenue that filed proxy statements between Oct. 1, 2009, and Sept. 30, 2010.

The results differ markedly from the April analysis, which covered 200 such companies and found median total direct compensation had dropped 0.9%.” (http://professional.wsj.com/article/SB10001424052748704756804575608434290068118.html?mod=wsjproe_hps_MIDDLESecondNews.)

The largest companies in the United States and their chief executives seem to be doing just fine, thank you. Plus, these companies are able to raise debt at record low interest rates and they seem to be piling up cash as fast as they can.

Recent headlines also reported that the income distribution in the United States again has moved more and more toward the wealthier end of the spectrum.

And, what do the policymakers and economists supporting the administration recommend? More spending because the administration has been too timid. More liquidity for the financial markets because we are in a liquidity trap.

Will this continue to be the economic policy of the Obama administration going forward?

I see no indication that it’s economic policy will change. And, if this is the case then this environment should drive investment decisions going forward.

The foundation of these investment decisions, I believe, is that the “largest U. S. public companies” will continue to prosper. The economic policies being proposed have little or nothing to do with resolving the underlying economic imbalances that exist in the United States and that is why the recovery, as it continues, will be skewed toward the larger companies.

Of course, not all of the largest U. S. public companies are going to thrive, but I believe that this is where a lot of the action will be. The action will be in the following companies: companies that will be bought by the large companies building up the large piles of cash; the companies that are engaged in “bubble” assets like commodities, emerging market financial instruments, and bond markets; and a select few companies that are doing the buying of the smaller companies.

I don’t immediately like companies that are doing the acquiring because mergers and acquisitions don’t always work out. In fact, my research indicates that at least two-thirds of the corporate combinations don’t work out. First off, those that move earlier tend to fare better because the acquisition prices don’t get inflated until the merger frenzy progresses: followers get killed. Second, I don’t trust a lot of executives in making mergers work. So many get caught up in “ego” problems that they either overpay for the target or move to make mergers without the culture or the expertise to pull off the acquisitions.

This makes the potential targets for takeover extremely attractive. Why? Because the targets in this instance will be those companies that are not performing well due to the recession and the tepid recovery and the price of their stocks will be relatively low with few prospects, except for being acquired, for they are still basically struggling companies.

To me the pieces are in place for a substantial consolidation of companies in the United States. The largest companies have cash and will have the ability to garner much more as they need it. Note: this just came across the net: Caterpillar Strikes $7.6 Billion Deal for Bucyrus. Caterpillar is offering $92 a share in cash for Bucyrus, a 32 percent premium, as the heavy equipment colossus makes a big push into mining equipment.

Alright!

The executives of these companies stand to make lots and lots of money by making their companies bigger, whether or not they make them bigger successfully. Given the information presented above, this seems to have already started. Continuing the government’s existing
economic policy will see this environment lasting for quite some time.

Companies dealing in “bubble” assets can obviously benefit from “going to the dance.” The downside is “staying too long at the dance.” But, the Treasury and the Fed have signaled that their current policies will continue for “an extended time.” Let the music play on.

The results of this? The income distribution will continue to skew toward the wealthy end. Big businesses will get bigger. Small businesses will do alright, but they will be on the periphery not at the center and will be devoted more to upper income tastes. Employment will continue to be weak because mergers and acquisitions tend to result in layoffs and a shrinking workforce rather than an increasing one. Capital investment will not be too lively because mergers and acquisitions, at first, result in the scrapping of old physical plant and equipment and not the expansion of it.

Basically, the scenario I have described translates in the following way: the stimulus is going to be paper, and, therefore, the profits and wealth that are going to be created are going to be primarily paper.

Money will be made in this environment…lots of it! Just don’t remain too long at the dance!

Corporations are Hoarding Cash and Keeping Their Powder Dry

There is a great deal of discussion these days about all the cash that corporations are holding. This issue made the lead article in the Wall Street Journal on Monday, October 4. This issue is also connected with the move by many corporations to issue new debt with interest rates so low. This made the front page of the New York Times on Monday, October 4. (See Graham Bowley, “Cheap Debt for Corporations Fails to Spur Economy,” http://www.nytimes.com/2010/10/04/business/04borrow.html?_r=1&scp=4&sq=graham%20bowley&st=cse.)

People continue to believe that the issuance of more debt and the hoarding of more cash will eventually lead to more corporate investment which will spur on the economy and help achieve the recovery everyone wants so badly.

A recent commentator to this blog is skeptical of such occurrence because the amount of debt still outstanding in the corporate sector far exceeds the cash that is being held.

First, let me say that, like the commercial banking sector, there are some corporations that are piling up cash and issuing debt to pile up cash, and there are many more corporations that are facing solvency problems and have way too much debt for them to handle.

That is, there is a huge separation at this time between those banks and corporation that have and those that are drowning.

The macro issue of the relationship between debt and cash is not as relevant as is the micro issue of who has the cash to play with and who is still way over-leveraged.

The United States economy is at the point where a major re-structuring of the manufacturing and financial base is taking place. I have written about this over and over again and I have emphasized that the economic policy of the federal government has created a credit inflation over the past 50 years that has resulted in the need for this massive re-structuring.

Who would have ever imagined twenty years ago, for example that General Motors would ever need to be bailed out as it was last year? Who would have ever imagined the need for the major pharmaceuticals and other industries to re-structure as they have been doing, consolidating, and scrambling for their lives?

And, as for the smaller companies? They seem to be stuck. They cannot raise funds from either commercial banks or from the bond markets. As Bowley emphasizes in his New York Times article, “Smaller companies continue to have trouble borrowing, and most of the new financing is limited to bigger corporations.”

The same thing is happening in the banking industry. The bigger commercial banks (the largest 25) prosper; many of the smaller commercial banks (about 7,800) are just holding on.

So we have this huge bifurcation of both the manufacturing sector and the financial sector. One part of each is piling up cash while the other part is just trying to keep its nose above water.

It is my bet that the companies that are building up their cash hoards are just waiting for the opportunity to sweep in and acquire firm after firm that are extremely weak. It is my guess that these companies are waiting for the right time to pick up their exposed brothers and sisters for a song.

They see the opportunity to participate in a complete re-structuring of the economic framework in the United States. The move depends upon two things. First, it depends upon the realization on the part of the weaker companies that they have little or no future without being acquired. Second, it depends upon some of the uncertainty surrounding the economic policy and regulatory philosophy that the federal government is going to finally decide upon.

The debt issuing and cash hoarding that is going on in both the banking sector and the manufacturing sector is not in preparation for hiring more people and buying more equipment. The corporations issuing debt and hoarding cash are preparing to build themselves by acquiring the assets and intellectual property of those companies that are not going to be able to make it on their own into the future.

Note, that this strategy WILL NOT increase jobs and investment in the near future. The strategy, like most mergers and acquisitions will result in cutting down and stream-lining the merged or acquired organizations. This strategy will result in more layoffs and the elimination of the excess capacity in the merged or acquired firms.

These activities will take several years to complete and, consequently, will not produce much economic growth over this time period.

Also, in both the manufacturing industry, as well as in the financial industry, this strategy will result in the big getting bigger. It seems as if the economic policy of the Obama administration is just exacerbating the distance between the small and the large. But, there is little that can be done now except attempt to create a “stifling” regulatory structure that clamps down on all mergers and acquisitions and creates an environment that is very unfavorable to business.

So, my conclusion is that the corporations that are issuing debt and building up their cash holdings are just increasing their ammunition for the up-coming economic re-structuring.
And, until that time occurs, they will just hold on to their ammunition and keep their powder dry

Is the Dam Starting to Break?

Over the past six months or so, I have commented on the buildup of cash at many of the major banks and manufacturing firms in the United States. My bet has been that at some point in the future, these cash hoards would be used by the large, healthy organizations amassing them to buy up other firms in a period of consolidation that would rival any other in United States history.

The growth of these cash hoards has been subsidized by the Federal Reserve System as it has kept its target interest rate near zero for twenty months and promises to continue to do so for an “extended time.” This has allowed large banks, non-bank companies, and investment funds to engage in the “carry trade”, regain their health and profitability, and build up their cash positions to historic levels. In so doing the Fed has underwritten a bubble in the bond market. (http://seekingalpha.com/article/221151-a-bubble-in-the-bond-market)

Behind this policy stance is the concern of the Federal Reserve for the solvency of large numbers of smaller commercial banks. On May 20, 2010, the FDIC claimed that there were 775 banks on its list of problem banks as of March 31, 2010. (The new list should be out any day.) As of last Friday, the FDIC had seen 110 banks close this year a rate of about 3.5 banks per week. Elizabeth Warren has stated in front of Congress that around 3,000 smaller banks face serious problems in the near future, especially in terms of commercial real estate. (http://seekingalpha.com/article/215958-elizabeth-warren-on-the-troubled-smaller-banks) For the problems of these smaller banks to be worked out in an orderly fashion, the Federal Reserve needs to keep interest very low well into 2011.

The consequence of this policy has been a bifurcation of American finance…and American industry. The bigger and better off companies have profited from the extraordinarily low borrowing costs and the promise that the huge, risk-free spreads that could be earned in the bond market would not go away soon. The smaller and less-well-off companies just held on, hoping that they would survive.

So, the bigger and better off companies built up their cash pools. The banks didn’t use the funds to make loans. The non-financial firms didn’t spend them to invest in new plant and equipment. The investment funds kept the perpetual money machines going. The question was, when would these organizations use these cash pools to begin the consolidation frenzy?

Now the Friday newspapers are full of the “deals” that have taken place this week. BHP has a $40 billion offer on the table for Potash Corporation. Intel is spending almost $8 billion for McAfee. Rank group has put out about $5 billion to acquire Pactiv and Dell has obtained 3PAR for a little over $1 billion.

And, in the banking area, First Niagara has paid $1.5 billion to acquire NewAlliance Bancshares. This latter deal seems to be particularly significant because both financial organizations are healthy. There have been many bank acquisitions over the past several years in which only one of the combining institutions have been healthy, but none where both have been in good shape.

This move by First Niagara is seen as something new in the current environment from both the company side, but also from the regulatory side. Regulators have been so pre-occupied in the past several years with problems in the banking space that little time has been available to give any attention to healthy combinations, if they existed. The announcement of this deal raises the question about whether or not more regulatory time will be given to healthy deals in the near future.

Bottom line: the cash is around in the coffers of many banks and non-financial companies. These organizations do not seem to be intent upon using these funds in a way that will speed up the economic recovery. The strategy seems to be to take part in a substantial consolidation and re-structuring of American finance and industry. The companies I would focus on at this time are those that are profitable, that have a large accumulation of cash, and that have the management team and will to lead this effort. As we saw in the buyout mania that took place in the late 1970s and 1980s, the best performers were the ones that moved first before higher and higher premiums were required to pull off deals. I believe that this will be the case in the present situation. Who said that the world was worried about companies that were “too big to fail”? They ain’t seen nothin’ yet!